The price of bitcoins, the newly created virtual currency and electronic payment system, has skyrocketed as investors and speculators seek to profit from buying and selling them in the marketplace. One surprising aspect of this phenomenon is that a major factor in driving the prices to new highs comes from a growing demand in China. The currency is gaining traction in China because of favorable media reports, an expanding number of online retailers accepting payment in the currency, and the country’s bitcoin exchange, BTC China. Investor optimism over Chinese demand for bitcoin has pushed up the price of the currency by 400 percent in the past three months.

The attractiveness of bitcoins in China stems from many other factors: the allure of a new and innovative financial technology, the many stories of people who purchased them on the cheap and are now rich, and finally the many possibilities opened up by the anonymous and untraceable nature of the currency, which has made bitcoins a favorite mode of transaction in illegal or illicit activities like drug trafficking and money laundering. This last factor will ultimately be the undoing of the currency in China.

The Chinese financial system is dominated by the role of the government. While the private sector has gradually displaced the state in the manufacturing and retail sectors of the economy, finance remains the domain of powerful state-owned enterprises. Beyond firm ownership, the dynamics of the financial market are heavily state-influenced through lending targets, interest rate controls, a managed exchange rate, and capital controls.

The reason for this level of government control is obvious. The financial sector has a large influence on the entire economy. Relaxing government control of finance means allowing the market to drive economic cycles to a greater extent than the Chinese leadership has been comfortable with.

This may well change with the new leadership of President Xi Jinping and Prime Minister Li Keqiang, which has publicly committed to allowing the market to play a “decisive” role in resource allocation. But if there is one guiding principle of the Chinese approach to reform, it is the strategy of gradual reform and experimentation. The Shanghai Free Trade Zone is a perfect example of this. Policymakers will experiment with small scale liberalization experiments that are easily controllable and do not endanger the overall economy.

A similar experiment may be taking place with bitcoins right now. The hesitation of Chinese regulators to ban the currency outright means that there is some degree of tolerance for virtual currencies. However, the currency will never be allowed to grow to the lofty role its supporters imagine. The record of regulatory action towards this end is clear. In 2006 the People’s Bank of China declared that it reserved the right to supervise virtual currencies if they affected the value of the renminbi. In 2009 the Ministry of Commerce banned the exchange of virtual currencies for real world goods. This was aimed at the QQ coin, a virtual currency that had grown in popularity on the QQ social network. In 2010, the Ministry of Culture banned online virtual currency platforms from offering services to minors.

All this suggests that the ultimate growth potential of bitcoins in China is severely limited and the trip wires for regulatory action are manifold. If the currency becomes a channel for the purchase of real world goods, it will likely be restricted. If bitcoins become a method for arbitraging or circumventing capital controls and thus affecting the value of the renminbi, they will be restricted. If bitcoins are used for illicit transactions or tax evasion in China, they will be restricted.

Financial liberalization is on the agenda in China and the government is committed to gradually loosening controls. The role of bitcoins in this process will be limited, however. The currency by its very nature is impossible for authorities to control and therefore its scope in China will remain limited. Large price fluctuations aside, don’t expect bitcoin to challenge the “people’s currency” anytime soon.

Update (12/5/13):

The People’s Bank of China issued a stern warning on its website on December 5th regarding bitcoins. The central bank declared that the virtual currency was highly speculative and a potential conduit for money laundering and criminal activity. Financial institutions and payment companies are banned from offering services in bitcoins. Exchanges and websites using bitcoins are required to create a user identification registry.